Without a crystal ball, most investors will diminish their returns by market timing. The legendary fund manager, Peter Lynch, has pointed out how quickly bull markets take hold, and how easy it has been to miss the early gains (which have made the difference between success and mediocrity).

This is not to say that market timing should be avoided. On the contrary, to ignore times of significant undervaluation and overvaluation in the stock market is foolish. It is just at these times, however, that the weight of evidence and expert opinion is biased in favor of the wrong decision. If you're unwilling to lean against the consensus and to give fair measure to valuations, great opportunities can become great disappointments.

Between the extremes of highly overvalued and undervalued stock markets, stock picking is the more important skill — and unlike market timing, one which can be done with consistent logic (since markets peak and trough at the irrational limits of greed and fear, by definition market timing can't be logical). At the current time, the stock market is neither extremely overvalued nor undervalued, though it is more expensive than cheap.

Your focus should be on finding stocks which will outperform, whose underlying companies deserve the benefit of the inevitable doubts in times of extraordinary stress and extraordinary potential. These are the companies which have sustainable competitive advantages, "good & great" managements and worthwhile valuations.

In determining absolute and relative values, rely on several different measures. My favorite is the expected return on investment based on free cash flow, since the value of a stock is the present value of the cash received over time. The first step is to estimate the free cash flow [for more info, go to Cash Flow].

Project the free cash flow ten years out, based both on historical growth rates and on your determination whether that historical growth rate will increase or, more likely, decrease. Then assign this projected free cash flow a terminal multiple based on the relative growth rate and the strength of the business model. Determine the implied capital gain based on the stock's current price and add in the dividend yield to estimate the expected return on your investment.

For those industries with large capital expenditures for growth, it's preferable to analyze future discretionary cash flow, in which only those capital expenditures which are necessary for maintaining 'normal' growth (6-7%) are subtracted from gross cash flow. The terminal multiples you use in this analysis should be considerably lower than those used in the free cash flow exercize.

Price/earnings ratios (P/Es) are overrated as a determinant of valuation since GAAP earnings don't clearly reflect financial reality, but when adjusted for the impact of options, P/Es are another helpful tool. Asset value and EBITDA are also useful measures, particularly in industries where acquisitions are common.

When brought together, these various approaches don't eliminate uncertainty (only in communism is there certainty about the future, even if the past keeps changing). With reasonable assumptions and sensible interpretations, however, these approaches do provide the opportunity to identify stocks which can outperform the market over time.

Beyond the guidance offered by your valuation work, you must also be willing, even eager, to be contrarian and bet against the crowd. Quicken.com provides a valuable resource in quantifying the popularity of a stock: after you bring up a quote, click on "Analyst Ratings" in the left column. An "Average Rating" below 1.6 is a red flag; a rating above 2.5 reflects a welcomed dose of unpopularity among Wall Street analysts.

Stock picking isn't an exact science — for most, it's an exercize in informed speculation. The stock market isn't a casino (offering bad odds wrapped up in excitement) nor do stock prices take a "random walk" over time as many professors would have you believe (the fact that the majority of money managers underperform the market over time provides a bizarre counterpoint to that argument).

Mr. Bond can make his killings at the bacarrat table (he does have a license, after all) and day-traders can speculate based on their whims and wants, but you should prefer to invest in the future of exceptional businesses. Stocks have their consistencies and their underlying logic — it's just a matter a finding the right mix of science and art, stirred not shaken.

Suggestion: Go to Intro to Stocks